Executed Guarantees

This is the second installment of a multi-part series about the Brazilian Garanteed Debt.
See Part 1.

This is the uncomfortable moment when the debt reaches the Federal Government in the process of issuing and monitoring guarantees. Most likely the negative effects of the default will burden the ordinary taxpayer. When the original debtor is unable to pay its own debt, the National Treasury, as the guarantor, must fulfill the obligation on behalf of the debtor. The creditor is not worse-off due to the guaranteed entity’s default because the guarantee was called. Why is it important for you to monitor executed guarantees?

On one hand, it’s true that debt leverages the current government’s capacity to invest. On the other hand, it reduces the government’s financial position in the future due to the obligations assumed over time. When the guaranteed entity starts to have problems to meet its financial obligations, it sends a strong signal that something is wrong with public or corporate finances, respectively, for local governments or SOEs.

Besides the reduction of investments to improve the public infrastructure, the effects of mismanaged public finances hamper the supply of public health care, education and security. Beyond that, many local governments have started to falter the payroll and to renegotiate payment with suppliers of good and services, creating fiscal arrears. That’s how the problem materializes to the citizen.

It’s desirable to take action to avoid this situation and to prevent public finances to enter into a negative spiral. That’s why it’s important to closely monitor the historical executed guarantees and the cost-risk indicators for the existing guaranteed debt. Financial institutions, policy makers and the overall public can scrutinize the frequency and size of default events between guaranteed entities and debtors in order to verify a fiscal deterioration that can later affect the society as a whole.

Scroll down the page to see historical data on executed guarantees as of Apr-20. That is, you can visualize the debt served by the Treasury on behalf of local governments.

The chart shows the evolution of cumulated guarantees executed by the Brazilian National Treasury

The first ever executed guarantee was undertaken in Apr-30th-2016, when the state of Rio de Janeiro (RJ) defaulted on a BRL 30.2 mn installment owed to AFD- the French Development Agency. The Treasury accessed the state and, when it became clear they wouldn’t meet their obligation, federal debt managers stepped in and fulfilled the debt.

Trailing from the severe financial distress, the state of Rio de Janeiro would sequentially default on various guaranteed payments forcing the National Treasury to fill in every occasion. As of Apr-20, the Treasury totaled to Rio de Janeiro's creditors, representing % of all executed guarantees.

From 2018 onwards the Treasury had also to step in the state of Minas Gerais (MG), which had defaulted guaranteed debt. The total volume of executed guarantees significantly increased from 2019 on when the Supreme Court (STF) started to rule against the ability of the Treasury to access the collateral posted by these guaranteed entities, breaching the contractual recovery mechanism designed to insulate the Treasury from credit risk.

For Minas Gerais, the increase in executed guarantees can be better observed from monthly data since 2019.

The chart now shows the number of payments undertaken by the Treasury, on a monthly basis, to honor the unpaid debt from states and municipalities.

Finally, each payment, each executed guarantee is represented by a circle in the chart. A total of payments were undertaken from Mar-16 to Apr-20.

Now, the circles are proportional to the size of each payment. These payments summed up to BRL .

The payments can be separated in domestic and external.

We now show the payments executed in the name of each state or municipality. The remaining entities were grouped into “other” as they are less representative.

Last, we show the payments by creditor.

Note that, since 2016, the distribution of executed guarantees already alerted the severity of the public financial crisis in the state of RJ. A year after the inaugural default, the state adhered into the Fiscal Recovery Regime (FRR - Complementary Law n. 159/2017), created by a new legislation to facilitate the fiscal consolidation for states under fiscal disarray. Among other provisions, the FRR suspends the state debt service with the Federal Government (as the creditor) and impairs the Treasury to recover the collaterals embedded in the guaranteed contracts if the state defaults for up to 36 months. Also, a set of measures must be taken by Rio de Janeiro state to adjust its fiscal side. This context explains the increase in the frequency and size of RJ’s executed guarantees.

RJ is not alone in this worrisome situation. The Supreme Court has issued legal injunctions impairing the Treasury to execute the collaterals under the agreed contractual terms. The political economy has favored the credit-delinquent entities imposing a transfer of resources from federal to local governments. Recovering the collateral posted by the guarantees beneficiaries was one of the most effective disciplinary mechanisms to curb debt defaults. In fact, it is one of the cornerstones of the guarantees system, which has been weakened by the legal instability created by the Supreme Court. As it can be seen in the charts, the state of MG was one of the first entities to benefit from the favorable injunctions coming from the Supreme Court.

The spread of legal injunctions from the Supreme Court to other entities has debilitated the guarantees system, motivating the defaulted entities to hold back their own reform agenda and to delay their fiscal consolidation. In addition, it creates an adverse incentive to financially sound entities to stop paying the debt. The Treasury financial position is harmed because of the materialized contingent liability and the inability to collect the assets which is entitled to. The Supreme Court ruling is considered the main reason behind the steep increase in the number of called guarantees during the past years.

The resulting effect is the increase in the federal government financial spending. Therefore, there is a socialization of the losses imposed by a few entities to the whole society, translated either into increase of future taxes or reduction in budgetary resources to provide public goods and services in health care, education and infrastructure. In practice the losses imposed by defaulted local debt are shared by all Brazilians.

Executed guarantees is one of multiple indicators that can alert to cash flow problems of public entities. Even because states and municipalities can also get credit from other non-guaranteed mechanisms. That’s why it’s useful to understand the size of the guaranteed debt over the total indebtedness of local governments.